Design a project based on the learning outcomes and integrating current events.
Instructions: This project will reference the “FINANCIAL CRISIS” case titled “The American
Recovery and Reinvestment Act of 2009,” found on page 200, for every Unit in
this course. As a financial consultant, you will apply the knowledge gained in this
course to attempt to change the outcome of the case to a positive one. At the
end of each Unit, prepare a report that answers the pertinent questions
regarding the Unit content as it pertains to this Case. The questions applying to
Unit Four are described below:
a. A medium-sized company is planning to undertake a series of new projects. What
kind of decisions would the firm need to make about cost of capital given their
improved cash position? Cite sources with in-text citations.
b. Your small business client has decided to act on an investment his best friend told him
about instead of taking your advice. His best friend is a millionaire but after investigating
you are sure your client could put his additional cash to better use. How do you address
this herd behavior and put him back on the right track? Cite sources with in-text
citations.
c. Your medium-sized business client is trying to decide how much debt he wants to take on
for a new project How do you help her understand that risk and cost of capital for
levered equity will be different than that risk and return of un levered equity? Cite
sources with in-text citations.
Write a 3 to 5 Page paper (1000 to 1500 words) in APA format.
Below is a recommended outline.
1. Cover Page (See APA Sample paper)
2. Introduction
a. A thesis statement
b. Purpose of paper
c. Overview of paper
3. Body
4. Conclusion – Summary of main points
a. Lessons Learned and Recommendations
S. References – List the references you cited in the text of your paper according to APA
format.
(Note: Do not include references that are not cited in the text of your paper)
200 Chapter 7 Fundamentals of Capital Budgeting
The American ReCOVBir”’t!
and Reinvestment
Act of 2{,W9
On February 17, 2009, President Obama signed into law
the American Recovery and Reinvestment Act. The Act, like
the earlier Economic Stimulus Act of 2008, included a
number of tax changes designed to help businesses and stimulate investment:
Bonus Depreciation. The Act extended a temporary rule
(first passed as parr of the Economic Stimulus Act of 2008)
allowing additional first-year depreciation of 50% of the
cost of the asset. By further accelerating the depreciation
allowance, this measure increases the present value of the
depreciation tax shields associated with new capital expenditures, raising the NPV of such investment.
Increased Section 179 Expensing of Capita! Expenditures.
Section 179 of rhe tax code allows small- and medium-sized
businesses [0 immediately deduct the full purchase price of
capital equipment rather than depreciate it over time. Congress doubled the limit for this deduction [0 a maximum of
$250,000 in 2008, and this higher limit was extended by
the Act through 2009. Again, being able to receive the tax
deductions for such t.,xpenses immediately increases their
present value and makes investment more attractive.
Extended Loss Carrybacks for Small Businesses. Under the
Act, small businesses could carry back losses incurred in
2008 for up [0 five years, rather than two years. While this
extension did not directly affect the NPV of new investments, it meant struggling businesses were more likely to I
receive refunds of raxes already paid, providing much- I
needed cash in the midst of the financial crisi~ ~
7.5 Analyzing the Project
When evaluating a capital budgeting project, financial managers should make the decision
that maximizes NPY. As we have discussed, to compute the NPV for a project, you need
to estimate the incremental cash flows and choose a discount rate. Given these inputs, the
NPV calculation is relatively straightforward. The most difficult part of capital budgeting
is deciding how to estimate the cash flows and cost of capital. These estimates are often
subject to significant uncertainty. In this section, we look at methods that assess the importance of this uncertainty and identify the drivers of value in the project.
When we are uncertain regarding the input to a capital budgeting decision, it is often useful
to determine the break-even level of that input, which is the level for which the investment
has an NPV of zero. One example of a break-even level that we have already considered is
the calculation of the internal rate of return (1RR). Recall from Chapter 6 that the 1RR of
a project tells you the maximal error in the cost of capital before the optimal investment
decision would change. Using the Excel function 1RR, the spreadsheet in Table 7.7 calculates an IRR of24.1 % for the free cash flow of the HomeNet projecr.
12
Hence, the true cost
of capital can be as high as 24.1 % and the project will still have a positive NPY.
I Year o 2 3 4 5
NPV ($OOOs) and IRR
Free Cash Flow
NPV at 12%
IRR
(16,500) 5,100
5,027
24.1%
7,200 7,200 7,200 2,700
7.5 Analyzing the Project 201
Parameter Break-Even Level
Units sold
Wholesale price
Cost of goods
Cost of capital
79,759 units per year
$232 per unit
$138 per unit
24.1%
There is no reason to limit our attention to the uncertainty in the cost of capital estimate. In a break-even analysis, for each parameter, we calculate the value at which the
NPV of the project is zero. 13 Table 7.8 shows the break-even level for several key parameters. For example, based on the initial assumptions, the HomeNet project will break even
with a sales level of just under 80,000 units per year. Alternatively, at a sales level of
100,000 units per year, the project will break even with a sales price of $232 per unit.
We have examined the break-even levels in terms of the project’s NPV, which is the most
useful perspective for decision making. Other accounting notions of break-even are sometimes considered, however. For example, we could compute the EBIT break-even for sales,
which is the level of sales for which the project’s EBIT is zero. While HomeNet’s EBIT
break-even level of sales is only about 32,000 units per year, given the large up front investment required in HomeNet, its NPV is -$11.8 million at that sales level.
Another important capital budgeting tool is sensitivity analysis. Sensitivity analysis breaks
the NPV calculation into its component assumptions and shows how the NPV varies as
the underlying assumptions change. In this way, sensitivity analysis allows us to explore the
effects of errors in our NPV estimates for the project. By conducting a sensitivity analysis,
we learn which assumptions are the most important; we can then invest further resources
and effort to refine these assumptions. Such an analysis also reveals which aspects of the
project are most critical when we are actually managing the project.
To illustrate, consider the assumptions underlying the calculation of HomeNet’s NPV:
There is likely to be significant uncertainty surrounding each revenue and cost assumption. Table 7.9 shows the base-case assumptions, together with the best and worst cases,
for several key aspects of the project.
Parameter Initial Assumption Worst Case Best Case
100 70 130
260 240 280
110 120 100
2100 3000 1600
25% 40% 10%
12% 15% 10%
Units sold (thousands)
Sale price ($/unit)
Cost of goods ($/unit)
NWC ($ thousands)
Cannibalization
Cost of capital
13These break-even levels can be calculated by simple trial and error within Excel, or using the Excel goal
· ‘i[‘JI/1 i.
1′” r.Jfl-202 Chapter 7 Fundamenrals of Capital Budgeting
‘I.- t·l~ . ,e:: < < \ ,..,;0~’ ‘”,
, FiGURE, 7 _1’ ‘.’
~’3 _ :::_ :> • • < ~
HomeNet’s NPV Under
Best- and Worst-Case
Parameter
Assumptions
Green bars show the
change in NPV under the
best-case assumption for
each parameter; red bars
show the change under
the worst-case
assumption, Also shown
are the break-even levels
for each parameter.
Under the initial
assumptions, HomeNet’s
NPV is $5.0 million.
To determine the importance of this uncertainty, we recalculate the NPV of the
HomeNet project under the best- and worst-case assumptions for each parameter. For
example, if the number of units sold is only 70,000 per year, the NPV of the project falls
to -$2.4 million. We repeat this calculation for each parameter. The result is shown in
Figure 7.1, which reveals that the most important parameter assumptions are the number
of units sold and the sale price per unit. These assumptions deserve the greatest scrutiny
during the estimation process. In addition, as the most important drivers of the project’s
value, these factors deserve close attention when managing the project.
Units Sold
(0005 per year) 70
Sale Price
($ per unit) 260 280
Cost of Goods
($ per unit) 120 110 100
Net Working Capital
!t~
~i
($ millions)
/’ <,
3
2.1 1.6
Cannibalization
40% 25%10%
Cost of Capital
15% 12%10%
-4.0 -2.0 0.0 2.0 4.0 6.0
8.0
100 12.0 14.0
Project NPV ($ millions)
The current forecast for HomeNet’s marketing and support costs is $3 million per year during
years 1-4. Suppose the marketing and support costs may be as high as $4 million per year. What
is HomeNet’s NPV in this case?
We can answer this question by changing the selling, general, and administrative expense [0 $4
million in the spreadsheet in Table 7.3 and computing the NPV of the resulting free cash flow.
We can also calculate the impact of this change as follows: A $1 million increase in marketing
and support costs will reduce EBIT by $1 million and will, therefore, decrease HomeNet’s free
cash flow by an after-tax amount of $1 million X (l – 40%) = $0.6 million per year. The present
value of this decrease is
-0.6 -0.6 -0.6 -0.6
PV = — + — + — + — = -$1.8 million
1.12 1.122 1.12
3
1.124
HomeNet’s NPV would fall to $5.0 million – $1.8 million = $3.2 million.
David Holland, Senior Vice President and
Treasurer of Cisco, is responsible for
managing all funding, risk, and capital
market activities related to the firm’s $50
billion balance sheet.
QUESTION: What is the importance of considering free cash flow, as opposed to just the
earnings implications of a financial decision?
ANSWER: There is an adage saying,
“Cash flow is a fact and earnings are an
opinion.” Earnings use an accounting
framework and are governed by many
rules, making it hard to know what earnings tell the investor. The economics of
cash flow are clear: We can’t dispute
whether cash has come in or gone out.
Cisco’s investment decisions are based primarily on cash
flow models because they take project risk into account
and show the impact on value creation for owners of the
business.
QUESTION: What key financial metrics does Cisco use to
make investment decisions?
ANSWER: Cisco focuses primarily on net present value
(NPV) for investment decisions. Robust NPV analysis goes
beyond simply accepting projects with positive NPVs and
rejecting those with negative NPVs. It identifies the key
drivers that affect project success and demonstrates the
interplay between factors that affect cash flow. For
example, running a model using a lower margin approach
shows us the impact on revenue growth and on operating
cost structures. \Y/e can compare that ro a higher margin
(premium pricing) approach. The business unit manager
learns how to control aspects of the business model to alleviate risk or accelerate the upside potential.
We prefer NPV to internal rate of return (IRR), which
may return multiple answers or give false signals as to an
investment’s profitability, depending on the organization of
cash flows. An attraction of IRR analysis is the ease of
comparing percentage returns. However, this method hides
the scope of a project. A project with a 25% return may
generate $1 million in shareholder value, while another
with a 13% IRR might produce $1 billion. NPV captures
the size of the return in dollar terms and shows a project’s
impact on share price. NPV also creates an ownership
7.5 Analyzing the Project 203
framework for employees whose compensation package includes some form of
stock ownership, directly tying the
decision-making criteria to stock price.
QUESTION: When developing a model to
analyze a new investment, how do you deal
with the uncertainty surrounding estimates,
especially for new technologies?
ANSWER: Cisco relies on strong financial
modeling for the thousands of investment
decisions we make every year. Our 2500
finance people worldwide work with the
internal client-the business lead-to
understand the assumptions in the model
and to check the model’s result against
alternative assumptions. Evaluating the
cash flows for technology projects, especially new technology, is difficult. When you buy an oil
refinery, you can see the throughput and the cash flows.
Identifying the relevant savings from a component technology for a larger router or switch product or a strategic
move into a new area is more complex and intangible. Scenario and sensitivity analyses and game theory help us control risk by adjusting our strategy. We also look at the
qualitative aspects, such as how the strategy fits into the
customer sector and the directions customers are moving
with their tech platforms.
QUESTION: How does Cisco adjust for risk?
ANSWER: To stay competitive in the technology space, we
must be prepared to take some level of risk, even in down
markets. We apply the same discount rate to all projects in
a category, based on their market risk (i.e., sensitivity to
market conditions). We do not adjust the discount rate to
account for project-specific risks, because our required
return has not changed and that would distort the true
value of the company. To assess a project’s unique risks, we
model the upside or downside of cash flows with scenario
and sensitivity analysis. We might analyze the sensitivity of
a project’s NPV to a 1% change in both revenue growth
and operating costs. Then we run the model with other
assumptions, developing base, optimistic, and bearish
cases. We discuss these models with the business lead and
rerun the models based on their input. This process
improves our potential outcome and project profitability
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